Does 6,000 Percent Interest Make You a Loan Shark?

The recession in the U.K. has produced an explosion of payday lenders, with much of the action online.

Britons now take out more than 8 million short-term loans worth more than 2 billion pounds a year, at least double the amount in 2008, at theoretical annualized interest rates of 5,853 percent or more.

These "legal loan sharks" have become a big issue. According to the U.K. consumer group Which?, 38 percent of those who take out short-term loans use them to pay for essentials, such as food and fuel; a quarter repay other loans.

So should the government ban payday lenders, as some U.S. states have done? Or should it follow other European countries and cap interest rates? I think the answer to both questions is no, not least because most payday customers say they are getting a good deal.

The U.K.'s Financial Conduct Authority last weekdecided that payday lenders provide a needed service, and didn't recommend an interest-rate cap (it will reconsider next year). The FCA did, however, propose mandating more disclosure; "affordability" checks; and a two-time rollover limit for loans.

Wonga.com -- "wonga" is a British colloquialism for money -- is a young web-based business that last yearloaned 1.2 billion pounds. Push one sliding bar on the company's website to set the loan amount, and a second for the term (up to 30 days), and you get a simultaneous quote. After submitting, Wonga puts you through an in-house credit-check system, which includes the algorithms you produced while using the website (if you whack the cursor to the maximum loan right away, you're a higher risk, for example). Fifteen minutes later the money is sent to your account.

To critics this is a quick hit like crack cocaine, with similarly addictive effects. According to Wonga, it's the future of finance and 90 percent of users say they would recommend the service to a friend.

The FCA concluded the main payday lenders aren't loan sharks, but that there is a problem: A quarter of borrowers told the FCA they were pressured to roll over their loans and half said the lender didn't explain the dangers involved.

This is where the crazy annualized interest rates come into play. These are supposed to be very short term loans. They cost about 1 percent a day. If you were to keep rolling over your one week or one month loan for a year, the compounded interest rate would be 5,853 percent.

The European Union mandates that all loans have to advertise a rate calculated in this way. The number is largely theoretical, however: Wonga and an association representing eight of the other biggest payday lenders say they will only let customers roll over for three months, and they don't compound interest. Some smaller lenders lure their clients into multiple rollovers and compounding interest and that needs to be stopped, although the FCA says it is rare.

One answer would be to ban payday lenders. According to a 2007 study by two New York Federal Reserve economists, though, this would be counterproductive. They found that financial distress -- measured by bounced checks, complaints against debt collectors and lenders, and Chapter 7 bankruptcies -- rose in Georgia and North Carolina after those states outlawed payday lenders.

What about a cap on interest rates? A study for the EU found there was little if any evidence that countries with caps have fewer people with debt troubles, or that countries that introduced caps found problems reduced.

In the end, the question is whether payday lenders overcharge for their service or create traps for defaulters. With some exceptions, these companies don't seem to be price-gouging. Wonga's net profit margin last year was about 20 percent, similar to Goldman Sachs. The New York Fed study also found normal profit margins among U.S. payday lenders.

The Archbishop of Canterbury, Justin Welby, recently told Wonga's chief executive, Errol Damelin, that he will "compete you out of business" by supporting traditional credit unions. I think he will struggle: If a Church of England credit union makes the same kinds of loans to the same people at the same speed as Wonga, it is likely to end up charging similar interest rates -- and become a "loan shark" itself.

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